Insolvency: an evolving definition?

by Burton, Hughlene A.

Abstract- Several court cases provide guidance in determining the amount of a taxpayer's insolvency. These include early cases such as the 'United States v. Kirby Lumber Co (1931)' and the 'Dallas Transfer and Terminal Warehouse Co vs. Commissioner (1934)' cases. However, later cases are the best sources of standards for computing amounts of insolvency. They include 'Marcus Estate v. Commissioner (1975),' 'Hunt v. Commissioner (1989)' and PLR 9130005. In calculating the liabilities to be included, it is most advisable to consult such cases as 'Fulton Gold Corp v. Commissioner,' 'Crane,' 'Tufts' and 'Gershkowitz v. Commissioner.' Individuals should also take note of Rev Rul 92-53 which sets standards for identifying the amount of nonrecourse debt that are supposed to be included in the computation of insolvency in cases when the outstanding debt is more than the fair market value of the property that secures the debt. The position of IRS regarding the ruling is discussed.

Whether the taxpayer is insolvent is a vital consideration in
determining if debt forgiveness results in income to the taxpayer.
However, the code, IRS, and the courts have not provided an adequate
definition of the term, and there is confusion as to what assets and
liabilities are to be included in its determination. A recent IRS ruling
helps, but it is not the final answer.

What items must be included in a taxpayer's gross income? Gross income
is generally defined by exception. For example, IRC Sec. 61 requires
that "except as otherwise provided . . . gross income means all income
from whatever source derived." IRC Sec. 61 also provides a list of
specific items that must be included in gross income. One such item
specifically included by IRC Sec. 61(a) (12) is the discharge of
indebtedness.

A discharge of indebtedness occurs when a lender agrees to accept less
than face value for a debt. The taxpayer/borrower has income because his
net worth has increased as a result of this transaction. The amount that
must be included in gross income as discharge of indebtedness income is
the difference between the amount of debt outstanding and the fair
market value of the property used to satisfy the debt. This amount is
treated as ordinary income. In addition, a taxpayer may have capital
gain income if the taxpayer uses appreciated property to satisfy the
debt. The amount of the capital gain will be the excess of the fair
market value of the property used to extinguish the debt over the
taxpayer's basis in that property.

IRC Sec. 108 provides two exceptions to the general rule. The first
exception, contained in IRC Sec. 108 (a)(1)(A), excludes discharge of
indebtedness from gross income if the taxpayer has declared bankruptcy
under Title 11.

The second exception, provided in IRC Sec. 108(a) (1) (B), aids those
taxpayers that are technically insolvent before the discharge from
indebtedness but have not declared bankruptcy. Taxpayers that have
declared bankruptcy can be easily identified. However, determining
whether a taxpayer meets the definition of insolvency under IRC Sec.
108(d) (3) is a more difficult proposition.

The Basics as Set Forth in the Code

IRC Sec. 108(a)(1)(B), which provides that "gross income does not
include any amount which would be includable in gross income by reason
of the discharge of indebtedness of the taxpayer if the discharge occurs
when the taxpayer is insolvent," was modified by The Bankruptcy Act of
1980. Although that provision of the IRC may exclude from gross income
the gain from a discharge of indebtedness for taxpayers that are
insolvent, IRC Sec. 108(a) (3) limits the excludable portion to the
amount by which the taxpayer is insolvent. For example, if a taxpayer
owns assets with a fair market value of $50,000 and has liabilities of
$75,000, only $25,000 (the amount by which he is insolvent) can be
excluded if the liabilities were discharged. Therefore, the calculation
of insolvency becomes very important.

Little direction is given by the IRC on how to calculate the amount by
which a taxpayer is insolvent. Insolvency is defined as the excess of
liabilities over the fair market value of assets. The calculation of
insolvency must be determined on the basis of the taxpayer's assets and
liabilities immediately before the discharge. Problems have arisen in
the calculation of insolvency because there is no indication as to which
assets and liabilities must be included in the insolvency calculation.
In addition, no guidance was given in this area by the Congressional
committee reports on The Bankruptcy Act of 1980. The only guidance comes
from court cases that established the judicial insolvency exception
prior to The Bankruptcy Act. The question also has been addressed
recently in several revenue rulings. Generally, the case or ruling has
examined the inclusion of either assets or liabilities but not both at
the same time. Therefore, this discussion will address which assets must
be included first and then look at the treatment of liabilities.

Which Assets to Include

United States v. Kirby Lumber Co. |284 U.S. 1(1931) is the first case in
the evolution of the insolvency exception. In Kirby Lumber, the taxpayer
issued bonds which were later retired at less than par value. The
Supreme Court ruled the difference between the par value and the amount
paid to retire the debt must be included in gross income. The Court
reasoned the taxpayer had realized an actual increase in assets by this
amount. This decision developed the "fleeing of assets" doctrine, which
says that income is realized when a debt is discharged for less than the
full amount only if assets were freed from the claims of creditors.
Since the taxpayer had the use of additional assets in Kirby Lumber it
had to recognize income.

The Court in Kirby Lumber did not address the question of taxpayer
insolvency. This issue was first raised in Dallas Transfer and Terminal
Warehouse Co. vs. Commissioner |70 F. 2nd 95 (5th Cir. 1934). In Dallas,
the taxpayer was released from its indebtedness to its lessor by
conveying a piece of real estate. However, the value of the real estate
was less than the total debt. Before the transfer the taxpayer had a
deficit of $226,470. Though the release from the debt on its lease
reduced this deficit, the taxpayer was still insolvent after the
transfer. The taxpayer was insolvent both before and after the debt was
discharged. Thus, the Court determined that no income was realized
because no assets had been freed from the claims of creditors. It
further ruled that "taxable income is not acquired by a transaction
which does not result in the taxpayer getting or having anything he did
not have before. Gain or profit is essential to the existence of taxable
income." Therefore, since the taxpayer remained insolvent after the
discharge it did not realize a gain or profit.

The first case to address which assets must be included in the
insolvency calculation was Marcus Estate v. Commissioner (T.C. Memo
1975-9). In Marcus, the taxpayer died indebted to a corporation for
funds the corporation had advanced to him and for expenditures made by
the corporation on his behalf. Even though these advances were not
evidenced by promissory notes, the Court found the amounts represented
an obligation of the decedent. The Court also determined that a
forgiveness of indebtedness occurred at the taxpayer's death since the
executors of the estate had no intention of satisfying this debt and the
corporation's management had no intentions of trying to enforce it.
Therefore, the estate must report income unless it meets one of the
exceptions provided in IRC Sec. 108.

To determine the amount of income the estate must include, the Court
first considered whether the estate was insolvent. This required a
decision about which assets and liabilities are includable in the
calculation. The Tax court decided that assets exempt from creditor
claims did not have to be included in the taxpayer's calculation of
insolvency. This decision was based on the "freeing of assets" doctrine
developed in Kirby Lumber. The court rationalized that if income is only
realized to the extent assets are freed from creditor claims, only
assets subject to creditor claims should be included when determining
insolvency. This position is beneficial to taxpayers, because it reduces
the asset base and thereby increases the potential of meeting the
insolvency test. Increasing the extent to which a taxpayer is insolvent
reduces the amount of taxable income.

The 1975 Marcus decision was reached before IRC Sec. 108 was amended.
The asset question also has been addressed several times since IRC Sec.
108 was modified in 1980. One such case, Hunt v. Commissioner (T.C. Memo
1989-335) examined the difference between assets exempt from creditors
under state law and those exempt under bankruptcy laws. The Tax Court
followed Marcus Estate in this case by excluding assets exempt from
creditors under state law. However, the Court rejected the idea assets
exempt from creditor claims under bankruptcy laws also should be
excluded from the calculation.

The Court said Congress anticipated different treatment for taxpayers
who had filed for bankruptcy under Title 11 and those taxpayers who were
merely insolvent. Their intention was codified in the two separate
exceptions under IRC Sec. 108 described earlier. Therefore, the
definition of insolvency is irrelevant to bankruptcy cases. As such,
only assets excluded from creditor claims under state law can be
excluded from the determination of insolvency under IRC Sec. 108(a) (1)
(B). By disallowing the exclusion of assets exempt from creditor claims
solely due to bankruptcy laws, the Court reduced the extent of the
taxpayer's insolvency and in turn, increased the amount includable in
gross income.

The Hunt decision was recently upheld in PLR 9130005. In this ruling,
the taxpayer's personal residence was foreclosed under a non-judicial
foreclosure proceeding. At the time of foreclosure, the residence was
worth $100,000 and the mortgage balance on the residence was $122,000.
Under the laws of the taxpayer's state, the creditor cannot collect from
the debtor a deficiency that results from a nonjudicial foreclosure. In
this instance, the creditor may claim only the assets collateralizing
the debt. Therefore, the taxpayer has discharge of indebtedness income
to the extent of the difference between the fair market value of his
personal residence and the face amount of the outstanding debt. This
amount must be included in gross income unless the taxpayer meets one of
the exceptions under IRC Sec. 108.

The IRS used the rules set forth in Hunt and concluded that all assets
exempt from creditor claims under state law could be excluded in the
determination of insolvency under IRC Sec. 108(d) (3). However, because
the taxpayer had not filed for bankruptcy, the taxpayer could not
exclude assets exempt from creditor claims under bankruptcy laws.

Applying the Theory to the Facts

Although the private letter ruling establishes values for the mortgage
debt and the home, it does not provide any amount for the income to be
recognized or the extent of insolvency. However, an attempt to apply the
theory to the known facts results in a very interesting conclusion.

Under state law, the creditor was precluded from collecting any asset
other than the residence. Since all of the taxpayer's other assets are
free from claims, none of the assets should be used to measure the
insolvency. The result is the taxpayer is insolvent for the full amount
of the debt in excess of the residence's value and would have no
recognized income from discharge of the debt.

This conclusion is fully in keeping with the "freeing of assets" theory
of Kirby Lumber. However it is contrary to the economic result in other
cases. A good example is Millar (67 TC 656). In this case, the taxpayer
surrendered stock in cancellation of debt. The Tax Court held the
taxpayer was required to report a gain equal to the amounts of the debt
canceled in excess of the value of the property surrendered. The amount
reported as a gain is the same amount that the taxpayer would have
reported as forgiveness of indebtedness income. However, because the
asset surrendered was a capital asset, the income was characterized as
capital gain. If this rule is applied to PLR 9130005, the taxpayer would
have to report capital gain without regard to any insolvency.

Liabilities to Be Included

The issue that appears to be the most crucial in this area is the
classification of the liability between recourse and nonrecourse. If a
liability is recourse, it appears the full amount of that liability is
included when calculating insolvency. However, the rule for nonrecourse
debts is not as clear-cut. Before discussing the effect of nonrecourse
debt on insolvency, it is helpful to review the relevant history of
nonrecourse debt.

One of the first cases which ruled on the inclusion of forgiveness of
indebtedness income due to the discharge of a nonrecourse mortgage was
Fulton Gold Corp. v. Commissioner. In this decision, the Court ruled the
taxpayer must reduce the basis of the property attached to the
nonrecourse debt by the amount that was forgiven instead of recognizing
the amount forgiven as income. IRC Sec. 108(c) (5) contains a similar
rule, which permits a basis reduction for adjustments made to
liabilities incurred to acquire property. It is the IRS's position that
these reductions are limited to debt held by the vendor of the property.

In Crane, the Supreme Court ruled nonrecourse debt should be included in
both the basis and amount realized on disposition of the property. The
Court left unanswered the question of the proper amount realized when
the debt exceeded the fair market value of the property. This issue was
addressed in Tufts. In Tufts, the taxpayer sold property which was
subject to a nonrecourse note that exceeded the value of the property.
The sale in question consisted of a third party assuming the existing
mortgage. In calculating the gain, Tufts reported the fair market value
of the property as the sales price. The Supreme Court ruled the amount
realized on the sale equaled the face amount of the note and the fair
market value of the property was irrelevant. They justified this ruling
by concluding that since a taxpayer treats a nonrecourse debt as true
debt upon inception, it must be treated as a true debt when discharged.
To allow a taxpayer to limit the amount realized on the sale to the fair
market value of the property sold would permit the taxpayer to recognize
a tax loss without a corresponding economic loss. The Tufts decision was
expanded by Gershkowitz v. Commissioner. In this case, the taxpayer had
loans outstanding to a third party which were secured by stock. When the
two parties decided to terminate their relationship, the outstanding
loans totaled $250,000, while the value of the stock securing the loan
was only $2,500. To affect the termination, the taxpayer paid the lender
$40,000 in cash. In return, the lender canceled the debt and
relinquished its rights to the stock. Relying on Tufts, the Tax Court
ruled the taxpayer had relief of indebtedness income of $210,000 (the
difference between the face amount of the loan and the amount paid). The
fact the taxpayer made a cash payment in Gershkowitz does not change the
outcome. Based on these cases the IRS now follows the rule that a
taxpayer has forgiveness of indebtedness income when all or part of the
liability is discharged even though there has not been a disposition of
the collateral.

The court cases have addressed how to treat nonrecourse debt when
determining the amount of forgiveness of indebtedness income. A more
recent ruling, Rev. Rul. 92-53, addresses the issue of nonrecourse debt
when calculating insolvency under IRC Sec. 108(d) (3). Specifically,
this ruling sets guidelines for the amount of nonrecourse debt to be
included in the insolvency calculation when the outstanding debt exceeds
the fair market value of the property that secures the debt.

Preserving a Fresh Start

As is true with assets, the IRC also does not define the term liability
as it is used for purposes of calculating insolvency. However,
legislative history implies insolvent taxpayers should not be subject to
tax on the discharge of indebtedness to preserve the "fresh start," the
discharge has allowed. Therefore, the amount by which a nonrecourse debt
exceeds the fair market value of the underlying asset should be included
as a liability when determining insolvency. The IRS agreed with this
position in Rev. Rul. 92-53, but limited the amount of excess
nonrecourse debt included as a liability under IRC Sec. 108(d) (3) to
the amount of debt that was discharged. In addition, the ruling explains
this amount is included in the definition of a liability whether it is
the only debt discharged or whether the nonrecourse debt is part of a
pre-arranged work-out plan in which both nonrecourse and recourse notes
are extinguished.

The position that only the discharged portion of the nonrecourse debt is
included stems from the IRS's position that excess nonrecourse debt
which is not discharged does not affect on the taxpayer's ability to pay
taxes from the discharge of another debt. Therefore, they ruled that
nonrecourse debt which was not discharged should not be included in the
definition of liability under IRC Sec. 108(d) (3). This decision is
important because a taxpayer may be deemed to be insolvent concerning
the discharge of nonrecourse debt. If the debt to be discharged,
however, is a recourse debt, the same taxpayer may be solvent because
all of that person's assets are subject to claims and therefore included
in the solvency computation. Therefore, the nature of the debt may be
crucial to the decision of which debts need to be renegotiated.

The ruling illustrated this conclusion with the following examples.

Example 1: Assume that the taxpayer owns two assets, a building with a
fair market value of $800,000 and a second asset with a fair market
value of $100,000. The taxpayer has two debts, a $1,000,000 nonrecourse
debt secured by the building and a $50,000 of recourse debt. In the
first situation the creditor agrees to a reduction of $175,000 in the
nonrecourse debt, bringing it to $825,000. In calculating insolvency the
taxpayer's liabilities include the $50,000 recourse debt, the $800,000
nonrecourse (to extent of value) and the $175,000 nonrecourse debt
forgiven, totaling $1,025,000. The assets total $900,000. Therefore the
taxpayer is insolvent in the amount of $125,000. Since the forgiveness
exceeds the insolvency by $50,000, the taxpayer reports $50,000 income.

Example 2: The taxpayer transfers $40,000 of other assets in settlement
of the $50,000 recourse liability. None of the nonrecourse liabilities
were reduced: therefore, the total liabilities for insolvency are
$850,000 ($800,000 value of the nonrecourse asset plus the $50,000
recourse debt). The total assets are $900,000. Since the taxpayer is
solvent, he must report $10,000 of income.

Example 3: The nonrecourse liability is reduced by $175,000 as in the
first example and the $40,000 asset is accepted in settlement of the
$50,000 recourse debt as part of a work-out plan. The total liabilities
are $1,025,000 and the assets are $900,000. Therefore, of the $185,000
of debt reduction, $60,000 is reported as income.

The examples clearly illustrate the ruling. However, the ruling is
incomplete. There is no mention of Millar or PLR 9130005. Therefore,
there is no way to know why the $50,000 of other assets in excess of
recourse debt was used to compute insolvency when it is not available to
satisfy the nonrecourse debt. As previously indicated the question needs
to be resolved.

A question that now appears resolved involves partnership debt. Under
IRC Sec. 108(d) (6) and Gershkowitz, it is now settled that insolvency
is measured at the partner level and not the partnership level. This is
not as detrimental as it might first appear because the flow through of
the income will increase the partner's basis in his interest in the
partnership and thereby reduce future gain on disposition. In fact, it
can be argued that this basis increase should occur even if the income
is non-taxable because of a partner level insolvency.

Guidance Needed From IRS

The correct interpretation of Millar and PLR 913005 is unsettled. It may
be that a taxpayer who is insolvent for accounting purposes but solvent
under IRS rules and regulations would be better off letting the creditor
foreclose on the property securing a non-recourse debt rather than
negotiating a debt reduction. The foreclosure would generate a capital
gain, whereas the cancellation of indebtedness income would be ordinary
income. If this is true, it could be a reversal of some recent planning
ideas.

It would also be helpful if the IRS were to state its position
discussing both the asset and liability side of the insolvency question
at the same time. The statement should include when an exchange or
foreclosure will be treated as a sale of the property. In addition, the
theoretical justification of the conclusion should be fully discussed.
Only then will the taxpayer be able to correctly report the reduction in
liabilities.

Edward J. Schnee, PhD, CPA, is professor of accounting and director of
the Masters of Tax Accounting program at the University of
Alabama.

Hughlene A. Burton, CPA, is a doctoral student in accounting at the
University of Alabama.

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